A simplified employee pension (SEP) IRA is a written plan that allows an employer to make contributions toward his or her own (if self-employed) or employees’ retirement, without becoming involved in complex retirement plans such as Keoghs. The SEP functions essentially as a low-cost pension plan for small businesses.
In tax year 2019, employers can contribute a maximum of 25% of an employee’s eligible compensation, or $56,000, whichever is less. In future years the maximum contribution will be adjusted for cost-of-living adjustments as published by the IRS. Be careful not to exceed the limits; a non-deductible penalty tax of 6% of the excess amount contributed will be incurred for each year in which an excess contribution remains in a SEP-IRA.
For the self-employed in an unincorporated business, the contribution is 25% of the net profit from the business (not the gross income), less one-half of self-employment tax. The SEP calculation for unincorporated business is not at all straightforward because the sole proprietor has wages and is making a SEP contribution; the contribution is limited to 25% of wages after the SEP contribution is deducted. Because of the deduction, the official 25% contribution is effectively reduced to 20%. For example, a sole proprietor with self-employment income of $150,000 could contribute a maximum of $30,000 to his SEP.
An incorporated business, on the other hand, can contribute up to the full 25% of net profit, or $37,500 for an employee with W-2 income of $150,000.
Employees are able to exclude from current income the entire SEP contribution. The SEP is an employer-contribution-only plan, meaning that even if the business is a one person shop, it is the business that is making the contribution to the plan. However, the money contributed to a SEP-IRA belongs to the employee immediately and always. If the employee leaves the company, all retirement contributions go with the employee (this is known as portability).
The IRS regulations state that employers must include all eligible employees who earned at least $500, are 21 or older, and have been with a company for 3 years out of the immediately preceding 5 years. However, employers have the option to establish less-restrictive participation requirements, if desired.
An employer is not required to make contributions in any year or to maintain a certain level of contributions to a SEP-IRA plan. Thus, small employers have the flexibility to change their annual contributions based on the performance of the business.
There is no age limit on employees who receive contributions from the employer. However, an employee who has a SEP account must begin taking distributions around age 70 1/2.
One of the pluses of the SEP is that a SEP can be opened and contributions made until the company’s tax-filing deadline. For calendar-year corporations with a March 15 tax filing deadline, SEP-IRA contributions must be made by the employer by the due date of the company’s income tax return, including extensions. So the contributions are deductible for the tax year as if the contributions had actually been contributed within the tax year. For example, contributions before March 15 are deductible for the prior tax year.
Sole proprietors have until April 15, or to their extension deadline, to make their SEP-IRA contribution if they want a tax deduction for the prior tax year.
On the minus side, the SEP does not allow participants to borrow from their account, nor does it allow participants over age 50 to put away an extra $5,000 in catch-up contribution, or to grow those funds tax-free in a Roth. For those features one should consider a Self-employed 401(k).
The SEP-IRA enrollment process is an easy one. It’s generally a two page application process. The employer completes Form 5305-SEP. The employee completes the IRA investment application usually supplied by a mutual fund company or some other financial institution which will hold the funds. Nothing has to be filed with the IRS to establish the SEP-IRA or subsequently, unlike many other retirement plans that require IRS annual returns.
Contributions to SEP plans may be affected by contributions to other defined-contribution plans, as regulated by the “415 limit.” The 415 limit is the total maximum contribution allowed for defined contribution plans (not including catch-up for those over 50). In 2019, the 415 limit is the lesser of 100% of taxable compensation or $56,000. This limit may be especially relevant to an individual who has a business *and* a W2 from an employer. Within the 415 limit there is also a limit of $19,000 for salary deferral to a 401K. And if the employer makes an employer contribution to a SEP or 401K for a participant, then that participant must make sure that all these contributions do not exceed the 415 limit for the year. Refer to IRS publication 560.
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Contributed-By: Edward Lupin, Daniel Lamaute, Chris Lott